The Federal tax legislation enacted in December 2017 contained many changes that affect high net worth families and their investment and business activities. One change was to prohibit an individual’s deduction for miscellaneous itemized deductions that we have discussed in a prior article. Brief Recap: Miscellaneous itemized deductions consist of a hodgepodge of unrelated itemized deductions. This article will focus on the following deductions:

  • Expenses for the production or collection of income,
  • Expenses for the management, conservation or maintenance of property held to produce income, and
  • Expenses incurred to determine, to defend against an assessment or to seek a refund of any tax.

The expenses typically include, but are not limited to, investment advisory and management expenses, accountant fees and legal fees. For convenience, this article will refer to these expenses collectively as “investment expenses”. It is important to note that these same types of expenses (management, accounting and legal fees) incurred in connection with rental property or in the conduct of a trade or business are treated as deductible “rental expenses” or “business expenses” and are not “miscellaneous itemized deductions”. In addition, certain other types of itemized deductions, such as interest expense, taxes and charitable contributions continue to be deductible, albeit subject to a few new limitations imposed by the 2017 tax legislation.

Some history is helpful here. For many years now, the deduction for investment expenses was limited to 2 percent of the taxpayer’s adjusted gross income. Taxpayers could deduct investment management fees paid individually or through a family office. In 1991 Congress enacted the Pease limitation, which reduced the total amount of most itemized deductions by the lesser of 3 percent of the taxpayer’s adjusted gross income or 80 percent of the taxpayer’s itemized deductions. Between 2017 and 2026, taxpayers will no longer be able to deduct investment expenses to any extent. The prior limitations on itemized deductions, both the 2-percent-floor limit and the Pease limitation, have been suspended for the same period by the 2017 Tax Act.

The 2017 Tax Act presents a new dilemma for families that have created or intend to create formal family offices to manage their financial and personal affairs. The family office will not be allowed to deduct its expenses incurred in providing services to the family unless it is operated as a business. In addition, if the family office is formally structured as a separate legal entity, then the family’s payment of fees to the family office for its services may generate taxable net income for the family office (to the extent not offset by expenses). Finally, any fees paid by the family members to the family office that qualify as investment expenses will not be deductible. Fortunately, the Tax Court recently provided some useful guidance regarding each of these issues. Lender Management v. Commissioner, TC Memo 2017-246 (“Lender Management”). The court first determined that the activities of a family office that provided extensive investment management services, financial planning services, accounting and other similar services to an extended group of family members amounted to a trade or business. The court also reviewed and approved the use of profit interest to compensate the family office for its services — in lieu of the payment of what would probably have been nondeductible investment management fees paid by the family members.

The Lender Management decision thus provides an excellent summary of the legal and practical hurdles that a family must satisfy to qualify a family office as a business:

  • The management of investments for a family, even if continuous and regular and even with the intention of making a profit, does not by itself constitute a trade or business.
  • The activities of family members or a family office will be subject to “heightened scrutiny” to determine if the activities represent a bona fide, arm’s length business.
  • The family office should be compensated through the use of profit interest paid by the family investment funds that it packaged and managed.
  • Fees for investment advice and other services paid by family members will be treated as nondeductible investment expenses pursuant to the 2017 Tax Act.
  • The ownership of the family office should not be co-extensive with the family served. In this case, the family member that owned 99 percent of the family office owned less than 10 percent of the family investments.
  • The family office had several full-time employees and the family member that owned the family office worked full time.

The Lender family operated a family business that was sold in the 1980s. Some of the family members continued to invest the sales proceeds together. In 2005, the family office managed three investment funds that fulfilled different investment strategies. Of the founder’s five children, the family of two children participated in the family office investments. The IRS audited the family office in 2010-2013. By this time, the family office was owned (99 percent) by a member of the third generation.

During the years under audit, the family office provided a multitude of services to the family members on a regular and continuous basis, including:

  • Researched and selection investments for the family investment funds.
  • Provided — directly and through third-party providers — financial planning services to family members who were invested in the funds.
  • Provided accounting services to the family investors through third-party providers.
  • Met with family members on an individual and group basis.
  • Provided analysis of cash from sources and needs for family members and negotiated lines of credit and other financing needs.

The court noted that these services compared favorably to the services provided by third-party hedge funds and investment advisors.

The Tax Court identified several factors that supported the conclusion that the family office operated a business:

  • The family office was owned by one family member.
  • The family office was compensated primarily through profit interest in the family hedge funds. If the hedge funds were profitable then the family office would receive more compensation. The family office was therefore compensated only if it is was successful.
  • Individual family members invested in the selection of family hedge funds based on their respective investment goals. Individual family investors could withdraw their investments at any time subject to liquidity requirements.
  • The family hedge funds were designed to operate like (and in fact operated like) third-party hedge funds.
  • The family member that owned the family office company worked full time in the business and there were four other full-time employees.
  • The compensation payable to the family office greatly exceed the investment gains earned by the owner of the family office through his personal investments in the family hedge funds. This supported the conclusion that the owner of the family office was motivated more by the success of the family office than by his or her share of investments in the family hedge funds

The compensation structure of the family office in Lender Management presents another planning opportunity for families seeking to fund the operating expenses of a family office. In this case, the family office was compensated through the ownership of profit interest in the family investment funds offered by the family office. After the 2017 Tax Act, the payment of investment advisor fees or other costs to a family office by family members would be nondeductible as investment expenses. The payment of profits to a family office by the family investment funds compensates the family office in a tax-efficient manner because the profits paid to the family office reduce the taxable income of the family members without generating nondeductible investment expenses.

Taken altogether, the Tax Court concluded that the family office operated and managed its investments in the same manner as a third-party hedge fund and was therefore entitled to be characterized as a business for income tax purposes. In conclusion, the decision in Lender Management embraces two conclusions that may be adaptable to the situations of other high net worth families who are considering the creation of a family office and who are receiving services from a family office. First, when a family office is operated as a bona fide business for income tax purposes, the family office operating expenses consequently qualify as deductible business expenses for income tax purposes rather than as nondeductible investment expenses or itemized deductions. Second, using profit interest in the family investment funds to compensate the family office reduces the income of the family investors directly. If, alternatively, the family investors had paid an investment advisory fee to the family office for the same services, the fee would be a nondeductible itemized expense in 2018 as a result of the 2017 tax act.